Unit-2: Structure of Option Market

• Option is defined as a contract between two parties where

one gives the other the right (not the obligation) to buy or
sell an underlying asset as a specified price within or on a
specific time. The underlying may be commodity, index,
currency or any other asset.
• As an example, party has 1000 shares of Citizen Bank
whose current price is Rs. 200 per share and other party
agrees to buy these 1000 shares on or before a fixed date
(i.e. suppose after4month) at a particular price say it is
become Rs.210 per share.
• In future within that specific time period he will definitely
purchase the shares because by exercising the option, he
gets Rs. 10 profit from purchase of a single share.
 Features of Option
• Contract:
• Premium:
• Pay off:
• Holder and writer
• Exercise price
• Variety of underlying asset
• Tool for risk management
 Types of options
• Call option
It is an option which grants the buyer (holder) the right to buy an
underlying asset at a specific date from the writer (seller) a
particular quantity of underlying asset on a specified price within a
specified expiration/maturity date. The call option holder pays
premium to the writer for the right taken in the option.

• Put option
It is an option which confers the buyer the right to sell an
underlying asset against another underlying at a specified time on
or before predetermined date. The writer of a put must take
delivery if this option is exercised. In other words put is an option
contract where the buyer has the right to sell the underlying to the
writer of the option at a specified time on or before the option’s
maturity date.
• American option: American options are
options that can be exercised at any time up
to the expiration date. It provides the holder
or writer to buy or sell an expiry of the option.
• European options: European options are
options that can be exercised only on the
expiration or maturity date. It is clear that
American options are more popular because
there is timing flexibility to exercise the same.
European options are easier to analyse than
American options.
 Value of call option
• The value of option can be determined by taking the difference between
two or if it is not exercised then the value is zero.
• The value of call option at expiration is as follows:
Vc = Max (Vs – E, 0)
Where, Vc = Value of call option
Vs = Market price of stock at expiration
E = Exercise price
The difference (+ve) between the market price and striking price is the
reward for option holder. The call option buyer anticipate the upward
movement in stock price so that this is a bullish attitude.
Profit/loss = Value of call option – Amount of call premium = Vc – Pc
For example, if the exercise price is Rs 115 and current market price of the
stock is Rs 132, what is the value of call? If the option premium is Rs 10,
what is the profit and loss status for buyer?
If the strike price is Rs 20 and the option premium is Rs 2. Calculate the
profit and loss of option buyer and option seller at different market prices
(Rs 15, 17, 20, 23, 25, 30, 35)
 Value of put option
• The put option holder exercises the option if the stock price is lower
than the exercise price. The writer of the put option promises to buy
the stock. Put option gives the put holder the right to sell the
underlying assets at a specified price, within a specified period of time.
• The value of put option at expiration can be calculated as follows:
• Vp = Max (E – Vs, 0)
Where, Vp = Value of put option Vs = Market price of stock at
expiration E = Exercise price.
• The put option holder anticipating downward movement in the stock
price so that this is the bearish attitude.
• For example, if the exercise price is Rs 135 and market price of the stock
is Rs 115, what is the value of put? If the option premium is Rs 10, what
is the profit and loss status for buyer?
• Soln: Vp = Max (E – Vs, 0) = Max (135 – 115) = Rs 20
• Profit/loss = Vp – Pp = 20 – 10 = Rs 10
• If the strike price is Rs 20 and the option premium is Rs 2. Calculate the
profit and loss of option buyer and option seller at different market
prices (Rs 15, 17, 20, 23, 25, 30, 35)
 Basic Option Strategies
Analyzing payoffs and Profits
• Stock Transactions: Long Position In Stock
• Mr A agreed to purchase 100 shares of CZBIL
at Rs 200 and hold it for three months and
sold at Rs 170, 180, 190, 200,210,220and 230.
Calculate profit or loss at given market price.
Market price(ST) Purchase price(S0) Per share profit/loss Total profit/loss

170 200 -30 -3000

180 200 -20 -2000
190 200 -10 -1000
200 200 0 0
210 200 10 1000
220 200 20 2000
230 200 30 3000
 Stock Transactions: Short Position In
Stock
Purchase price(S0) Market price (ST) Per share profit/loss Total Profit/Loss

200 170 30 3000

200 180 20 2000
200 190 10 1000
200 200 0 0
200 210 -10 -1000
200 220 -20 -2000
200 230 -30 -3000
 Call Option Transactions:
Buy the call option
• Value of Call Option(VC) = Max[(ST - E), 0]
• Profit/Loss(∏) = VC - PC
• Mr A purchased call option for 100 shares of
CZBIL at exercise price of Rs 200 and hold it for
three months. Amount of premium per share was
Rs 10. The market price of stock at maturity date
was Rs 170, 180, 190, 200,210,220and 230.
• Calculate Initial cost of investor`s position,
breakeven stock price, value of call option and
profit/loss to option holder at maturity date
under each market price.
 Total Initial Cost of investors position
= Rs 10 × 100 Shares = Rs 1000
Break even Stock Price = E + PC
= Rs (200 + 10)
= Rs210
Pay off table for long call position
Price of Exercis Value of Premiu Profit/Loss per Total profit/loss
Stock(ST) e call option m share
Price(E) (VC) paid(PC)
170 200 0 10 -10 -1000
180 200 0 10 -10 -1000
190 200 0 10 -10 -1000
200 200 0 10 -10 -1000
210 200 10 10 0 0
220 200 20 10 10 1000
230 200 30 10 20 2000
BEP
 Call Option Transactions:
sell the call option
• Value of Call Option(VC) = Max[(ST-E), 0]
• Profit/Loss(∏) = PC - VC
• Mr A write (sold) an call option for 100 shares of
CZBIL at Rs 200 for three months. Amount of
premium received per share was Rs 10. Suppose
market price of stock at expiration date is Rs 170,
180, 190, 200,210,220and 230.
• Calculate option writer`s initial cash inflow,
breakeven stock price, value of call option and
profit/loss to option writer at maturity date
under each market price.
 Initial cash inflow to option writer
= Rs 10 × 100 Shares = Rs 1000
Break even Stock Price = E + PC
= Rs (200 + 10)
= Rs210
Pay off table for short call position
Price of Exercise Value of Premium Profit/Loss per Total profit/loss
Stock(ST) Price(E) call option received(P share
(VC) C)
170 200 0 10 10 1000
180 200 0 10 10 1000
190 200 0 10 10 1000
200 200 0 10 10 1000
210 200 10 10 0 0
220 200 20 10 -10 -1000
230 200 30 10 -20 -2000
Value of call option and profit and loss
to call option buyer and seller
 Put Option Transactions:
Buying a put option(Long put)
• Value of Put Option(VP) = Max[(E - ST), 0]
• Profit/Loss(∏) = VP - PP
• Mr A purchased put option for 100 shares of HGI
at Rs 400 and hold it for three months. Amount
of premium paid was Rs 25. The market price of
stock at maturity date was Rs 350, 375, 400, 425,
450 and 475.
• Calculate cost of investor`s position, breakeven
stock price, value of put option and profit/loss to
option holder at maturity date under each
market price.
 Total Cost of investors position
= Rs 25 × 100 Shares = Rs 2500
Break even Stock Price = E - PP
= Rs (400 - 25)
= Rs 375
Pay off table for long call position
Price of Exercise Value of Put Premium Profit/Loss Total profit/loss
Stock(ST) Price(E) option (VP) paid(PP) per share
325 400 75 25 50 5000
350 400 50 25 25 2500
375 400 25 25 0 0
400 400 0 25 0 0
425 400 0 25 0 0
450 400 0 25 0 0
475 400 0 25 0 0
 Put Option Transactions
Selling a put option(Short put)
• Value of Put Option(VP) = - Max[(E - ST), 0]
• Profit/Loss(∏) = ST - E + PP
• Mr A write put option for 100 shares of HGI at Rs
400 and hold it for three months. Amount of
premium received was Rs 25. The market price of
stock at maturity date was Rs 325, 350, 375, 400,
425, 450 and 475.
• Calculate initial Cash inflow of investor`s position,
breakeven stock price, value of put option and
profit/loss to option holder at maturity date
under each market price.
 Initial cash inflow to option writer
= Rs 25 × 100 Shares = Rs 2500
Break even Stock Price = E - P
= Rs (400 - 25)
= Rs375
Pay off table for short put position
Price of Exercise Value of Put Premium Profit/Loss Total profit/loss
Stock(ST) Price(E) option (VP) received(P) per share (100 Shares)

325 400 -75 25 -50 -5000

350 400 -50 25 -25 -2500
375 400 -25 25 0 0
400 400 0 25 25 2500
425 400 0 25 25 2500
450 400 0 25 25 2500
475 400 0 25 25 2500
Conclusion on Option fundamentals
Expansion of Underlying Assets
Development of Options Markets
• Early origins
• Put and Call Brokers and Dealers Association
• Chicago Board Options Exchange, 1973
• Resurgence of over-the-counter market
 Over-the-Counter Options Market
• Over the Counter (OTC) OTC options were written for
specific buyers by particular seller, and traded in the OTC
facilities. The cost establishing an of OTC options contracts,
however, are higher than for exchange options. Option
Exchange An exchange is a legal cAorporate entity organized
for the trading of securities, options, or futures which is
governed by corporate rules and regulations. It may utilize a
trading floor or may be an electronic exchange.
• Worldwide
• Credit risk
• Customized terms
• Private transactions
• Unregulated
• Options on stocks and stock indices, bonds, interest rates, commodities,
swaps & currencies
Over-the-Counter Options Market
Traders looking to buy options to hedge risk or simply
speculate in the options market may consider over the
counter options.
Over the counter options are not traded on an options
exchange and are essentially contracts between two parties.
There is no secondary market for such vehicles. Strike
prices are not standardized nor are expiration dates.
Traders may find great opportunities in over the counter
options but will need to be aware of the counter party risk
involved. In other words, in over the counter options trading
there is no clearinghouse to guarantee that both parties will
abide by the terms of the options contract. Over the counter
trading works much like standardized options trading in that
traders buy or sell puts and calls on an underlying equity.
Over-the-Counter Options Market
Sellers seek to profit from selling calls and puts but assume
the risk of loss in the agreement in return for a payment by
the buyer. One can trade stocks, bonds, commodities or
derivatives over the counter. Trading over the counter does
not in any way limit the range of options trading. Any
options agreement between two parties is possible. Options
over the counter use calls and puts just like standardized
options trading.
Options over the counter use calls and puts just. However,
expiration dates can be whenever the two parties wish them
to be standardized options trading. The strike price of a non-
standard option can also be subject to negotiation. Likewise
the terms of settlement may vary by contract. The major
risk of over the counter options trading is counterparty risk.
 Organized Options Trading
• The concept of an options exchange
• Listing Requirements
• Contract Size
• Exercise Prices
• Expiration Dates
• Position and Exercise Limits
An Option Transaction on a derivative Exchange
 Mechanics of Trading
1. Placing an Opening Order 9. In the exchange-listed
2. Types of orders options market
3. Role of the Clearinghouse 10. In the over-the-counter
4. Options Clearing options market
Corporation (OCC) 11. Exercising an Option
5. Clearing firms 12. European vs. American
6. Margin style
7. Open interest 13. Assignment
8. Placing an Offsetting Order 14. Cash settlement
Call Option Quotation
Put Option Quotation
 Types of Options
• Stock Options
• Index Options
• Currency Options
• Other Types of Traded Options
• interest rate options
• currency options
• options attached to bonds
• exotic options
• warrants, callable bonds, convertible bonds
• executive options
• Real Options
 Transaction Costs in Option Trading

• Floor Trading and Clearing Fees

• Commissions
• Bid-Ask Spread
• Other Transaction Costs
 The Regulation of Options Markets

• Federal regulation
• Industry regulation
• Over-the-counter market regulation
• The issue of which agency has
regulatory responsibility has
occasionally arisen.
THANK YOU